VIEWPOINTS : Brady Group's Answers Miss the Key Questions

LESTER C. THUROWLESTER C. THUROW is Gordon Y Billard Professor of Management and Economics and dean of the Sloan School of Management at Massachusetts Institute of Technology in Cambridge

An official government investigatory commission, the Brady Commission, has found that computer trading techniques played a big role in the Oct. 19 stock market crash. The evidence for this conclusion was found in the fact that a big fraction of the selling pressure came from large institutions using these techniques. No one denies that such firms sold lots of stock on Oct. 19 and 20, but does that lead to the conclusion that stock prices fell because these traders were using computer-driven trading techniques?

For the Brady Commission it did, but for the rest of us, it should not. The real causes are both more fundamental and more trivial.

Suppose that we are watching a herd of antelope in Africa and the dominant antelope starts to run. Quickly the whole herd is in flight. Did the first antelope to run cause the panicky flight? The proximate cause was certainly the dominant antelope--he was the first to run--but the ultimate cause may well have been the lions in the bush that he spotted. And if he was mistaken and there weren't any lions? Well, no one forced the rest of the herd to follow him. Each antelope individually decided to stay or run.

In the case of the stock market, the fundamental cause of the crash was an overvalued market. Historically, the U.S. stock market has never been able to maintain price-to-earnings ratios of more than 20-to-1 for any substantial period. Moreover, in early October, the price-to-earnings multiple on bonds was 10-to-1. Why would anyone pay over $20 for $1 dollar's worth of annual earnings capacity where there was another place, the bond market, where it could be had with less risk for $10? Such a situation could not long endure. The stock market was going to come down. The only question was when and how fast.

Economic historians will view October's events as a speculative bubble in the same category with tulip mania, the South Seas bubble or the Mississippi bubble. Speculative bubbles tend to end dramatically. In each of these cases, the market collapsed hundreds of years before computers, programmed trading or portfolio insurance were invented.

The operative question is why did the market rise to absurd levels, not why did it crash? Essentially, the Brady commission focused on the wrong question. Not surprisingly, by focusing on the wrong question, it came up with the wrong answers.

If one wants to know why the stock market plunged by 508 points on Black Monday, the truthful answer is that no one will ever know, just as today, nearly 60 years after the Great Crash of October, 1929, no one can tell you why the market collapsed. The precise reasons why a market crashes by a specific amount on a particular day are so trivial that they are difficult to isolate, but even if isolated, they are irrelevant. The causes of the crash are to be found in the previous overvaluation of the market and not in the events of the crash itself.

Computer trading isn't to blame for October's crash, but suppose that it were. How would you stop it? How would you prevent firms from using computers to figure out what they should buy and sell in the privacy of their own offices?

True, the New York Stock Exchange could make permanent its experimental restrictions on computerized program trading--curbs designed to shut down the exchange's high-speed order-execution system on days when the Dow Jones Industrial Average moves more than 75 points. Nonetheless, trading techniques are here to stay whatever the Brady Commission thinks and whatever laws are adopted.

The Brady Commission also suggests that broader use of stock trading halts is warranted. If stocks went up or down by some specified amount in a particular day, trading might be halted to give everyone time to think. Brokerage firms don't like such limits since they tend to limit trading volumes and hence profits. Brokerage firms, of course, can't make that straightforward argument and so they argue that limits reduce liquidity since there are more hours per year when you cannot sell or buy stocks. True, but irrelevant, given the number of hours available worldwide to sell or buy stocks.

While there is no evidence that markets with such daily trading limits are less efficient than those without them, there is also no evidence that stock prices in such markets fall by less in the midst of panics. Thinking can make one more, not less, panicky if there are real reasons for the market to fall. In the October crash, the markets with trading limits went down just as much as those without them.

In the aftermath of 1929, the speculations of J. P. Morgan Jr. were blamed for the crash and the Great Depression. No one takes this charge seriously now, but there was at the time a famous congressional hearing where a monkey was brought in to sit on Morgan's lap to humiliate him. In the same spirit, perhaps we could have a monkey operate a stock trading computer terminal for a day to show that the monkey could do as well as the humans who actually sit at those terminals.

It won't prevent the next crash, but perhaps it would make us feel better.